Martin Kropelnicki - VP, CFO and Treasurer Peter Nelson - President and CEO

Garik Shmois - Longbow Research Tim Winter - Gabelli & Company Jim Lykins - Hilliard Lyons Michael Gaugler - Brean Murray, Carret Heike Doerr - Janney Montgomery Scott

Good morning, everybody and welcome to the second quarter 2010 earnings conference call for California Water Service Group. With me today is Peter Nelson, President and CEO of California Water Service Group.

I would like to remind everyone that a replay of today's discussion will be available from July 29 through September 27 at 1-866-253-6505, ID number 1469346. Prior to looking at the results for the quarter, I would like to take a brief moment to discuss forward-looking statements.

In particular, during the course of this conference call, the company may make certain forward-looking statements because these statements deal with future events, they are subject to various risks and uncertainty and actual results could differ materially from the company's current expectations. Because of this, the company strongly advises all current stockholders as well as all interested parties to carefully read and understand the company's disclosures on risk and uncertainty found in our Form 10-K, Form 10-Q, and other reports filed from time-to-time with the Securities and Exchange Commission.

Having said that, let's jump into the quarter and go to the quarterly results and after I go through the results, I will hand it over to Pete, who will give you an update from an operational perspective. For the quarter, the company had revenue of $118.3 million, up $1.7 million or 1.4% over the same period last year.

There are four main components that drove the change in revenue. One, we had a rate relief at $8 million.

That rate relief can be broken into two buckets. Approximately $4 million of step increases that would have gross margin associated with the step increase and $4 million of offsets and offsets basically go to cover increase costs, but there is no gross margin that goes to the bottom line on that.

New customer revenue added approximately $600,000. Usage by existing customers was down $12.7 million and the net effect of the WRAM, MCBA and the WRAM is the water rate adjusted mechanism and then the modified cost balancing account was a positive $5.8 million.

Included in that debt number for the WRAM was the $5.3 million negative adjustments or reduction due to production costs being lower than the adopted numbers. Going down to the production costs and looking at operating expenses.

Operating expenses were up 1% or $1.3 million to $102 million for the quarter. Looking at the production costs.

There is three components of the production costs, purchase water, purchase power and pump taxes are all covered by the modify costs balancing account or the MCBA. Purchase water was up $753,000 or 2.4% for the quarter.

Overall, water production for the company was down 14%, but that was in the purchase water and was offset by higher wholesale water prices. Purchase power for the quarter was down $170,000 or 2.2% compare to last year and pump taxes were down $451,000 or 18.3% compare to Q2 2009.

Admin and general expenses for the quarter were down $904,000 or 5% to $18.5 million. That has to be primarily with our increase capital spending and more expenses being allocated to construction projects.

So people who will work on construction we allocate their time to the project and the overhead that follows or benefit costs follow that. Looking at other operations.

Other operations for the quarter increased $400,000 or 3% to $14.7 million. That was driven primarily by three categories.

One, increased spending on conservation. Two, cost associated with our front office and customer service.

Three, increased purchases of chemicals and filters. Maintenance expense for the quarter was up 20%, or $800,000, to $5.2 million.

This was driven by more maintenance on water maintenance which is typical this time of the year. Depreciation and amortization increased $400,000, or 4%, to $10.6 million, driven by the capital additions put into plan during 2009.

Income taxes were up $200,000 or 5%, to $4.1 million due to a slightly higher tax rate and property and other taxes were up $200,000 as well, primarily due to increased franchise fees and property taxes. Net operating income for the company was $16.3 million, up $329,000 or 2% over the same period last year.

Going down to other income and expense, other income and expense was breakeven and that compares to a positive $1.5 million last year. So that's a pretty big swing and that's primarily driven by a mark-to-market adjustment associated with assets that the company has associated with some of its benefit plans.

So the swing went from a positive 1.8 to a negative $700,000 and that's primarily reflected just in the volatility associated with the stock market that we saw during the quarter. Interest expense for the quarter was up $582,000 or 11% to $5.1 million and that's driven by the long term debt offering that was completed during 2009, plus the interest associated with the company's short term line of credit.

Earnings per share for the quarter were $0.50 per diluted share versus $0.58 per diluted share for the same period last year. I would now like to turn it over to Pete and then I will come back and talk about the balance sheet after Pete's done.

Pete?

I have got three or four issues that I am going to cover today. One is, I am asked all the time about politics in California.

I am sick with the Governor's race. We will talk about that and that impacts our regulation here.

So I will cover that subject. That will lead me to our major rate case proceeding versus our 2009 General Rate Case, which you heard about in pervious calls and we are approaching the finish line there and then I'll spend just a minute on a new operating contract that we announced in this quarter's press release, which was in Hawaii, which is a key contract for us.

So, first, the Governor's race, and this is important to us, because the Governor appoints commissioner to the Public Utilities Commission, as you know. The Governor also names the President of the Commission.

Now, his appointments have to be confirmed by the state Senate, so they are not immediately effective, but people can serve as appointed without being confirmed by the state's Senate for a year. Of the five seats on the commission, we expect three new appointments right after the first of the year.

If you haven't heard that two candidates we for governor are Jerry Brown, who is a long time public servant, well -known in the state, past governor, past mayor of Oakland and Meg Whitman, the Republican candidate, past CEO of eBay. This is her first campaign for elected office.

The polls are pretty close, shows the race is tossed up at this point, but there's three months to go. So we've had a lot of time here for the campaigning.

As far as the commission seats, two commissioners we expect to continue on, one is Timothy Simon, his term, it was through 2012, and Mike Peevey who is also the President of the Commission, his terms extends through 2013. One commissioner, Nancy Ryan has been appointed to the commission to fill an open seat, but she has not been confirmed by the state Senate yet.

So she can serve, as I mentioned one year without being confirmed by the Senate. Two commissioners are termed out and that's Commissioner John Bohn, who has been the water commissioner and Commissioner Dian Grueneich.

Their terms end this year and we expect those seats to be open for appointments. So, that's why I'm saying there are at least two and probably three seats to be filled on the commission.

The Public Utility Commission in California is probably the most visible and I think the most powerful commission in the state. So, we expect the appointments there to not to linger.

We expect the appointments to be made pretty quick after the Governor is in place and I am sure we will have a better handle on the election, I hope, by the next quarterly conference call. Also in the news lately in California, at least in California as the state's budget problem persists, we are at deficit again and the legislature is wrestling with the budget at the state capital and impact on us is basically through The Public Utilities Commission's staff budget.

The commission here is funded by a fee on every utilities customer's month bill. So, in effect you could say a large part of the commission's budget is outside of the state budget deficit, but the commission is still under pressure on staffing, of course.

I think this is good news for us because the last thing we need is a commission staff that's under staffed or furloughed, which delays rate proceedings, which are important to us. Which lead to our major rate case proceeding that we are in the middle of, which is our 2009 General Rate Case, as you have heard from me on the last few calls, this is our first company-wide General Rate Case covering the entire state, all 24 rate making districts and our corporate costs.

This, as might recall, is the largest most complex water case in the state's history coming from the commission. It's an 18 month long process.

We have filed the case in 2009 in July for new rates that should be effective January 1, 2011 and the decision covers rates effective 2011, 2012, and 2013. It's a three year rate case.

I struggle with an analogy here for, because I know this can be a very dry subject, and the best I have heard is Tour de France, which just concluded, which is also a long difficult arduous process in France and in our case we have been through the speed trials early on. We have been through the Alps.

We have been out of the Pyrenees, and we can see Paris on the horizon. We have gotten through this race, our team has key without a major crash and we have been through the usual expected flat tires and bumps in the road and poor weather, which is a long way to say essentially we're on schedule, the team and the Peloton is expected to cross the finish line in time for rates effective January 1, 2011.

In other words we are on schedule and expect to have new rates in effect January 1. Also, since our last call, on this rate case we announced that we have settled with the Department of Rate Payer Advocates which are called the commission staff on this case and that's important to us.

The settlement agreement is 600 pages long, it's available. If you like a copy we can send you an email of copy which is available for public but the settlement covers virtually every part of the rate case.

What we have agreed to and I'll round off the numbers here to the nearest million. It is about $34 million in new annual revenues starting the first of the year and then an additional $7 million in annual revenue for capital projects that we call advice letters.

What that means is the staff and we agreed that these project and there is a lot of these projects in this category. These projects are needed but the schedules are uncertain.

So we will build the projects and then file what's call an advice letter for each project before we put them into rate base and then ultimately into rates. So I would say, overall, we are pleased with the settlement.

We think it's reasonable, because specially in the capital area with the capital expenditures that have been adopted in the settlement are consistent with our capital and forecast, you'll hear from Marty, but the view is 2011, 12 and 13, so that looks good to us. The settlement also contains a couple of new things that we haven't had in past cases and one is pension costs, balancing accounts for pension costs which is a cost category that's very difficult to predict and that's what rate case is trying to do is to predict the future expenses.

In the case of pension cost, these have been probably the least predictable, one of the least predictable costs and so we agreed with the commission staff to balance the account even for pension costs which means we will collect the cost and then fully recover them assuming they are prudently incurred in rates. So the settlement now is in front of the administrative law judge.

The outcome is not certain, of course, yet because we need a proposed decision from the administrative law judge and then ultimately a decision from the commission which we expect in the fourth quarter. The last item I have is a new contract we announced in the press release which is for a water and waste water system in Hawaii on the Big Island, on the west coast of the Big Island in a resort area that is called or it is known as Hualālai.

This is a residential area plus a resort and a Four Seasons hotel. About 700 customers but some of those are large customers.

Term is three years and the numbers are small but this is a very good fit for us strategically because it's adjacent to our own systems at Kukio and close to our headquarters at the Waikoloa and Waikoloa village, part of the Kona and Kohala coasts. So this contract gives us a much broader footprint, fills in a service area for us and gives us a chance to have a better economy of scale on the Big Island.

That's my few issues. Now I'll turn this back to Marty to talk about the balance sheet.

A couple of highlights of the balance sheet for the quarter. Company funded CapEx for the quarter or for the six months ended, I should say, is about $48 million on a year-to-date basis.

Net utility plants is up approximately 9.4%, or $1.253 million, that's up from $1.145 million for the same nine-month period, or six-month period last year. Work in progress balance, so this is web construction work in progress was $124 million, up 6% during the quarter.

Cash flow from operations was up 6.5%. Again, this is the first line on the cash flow statement just from operations.

We ended the quarter $33 million in cash flow from operations, up from $31 million last year. The company's line of credit, we have borrowed about $55 million on a year-to-date basis on a $300 million line of credit.

So, now that we are into the higher summer months where typically we have more billings that will be used to fund our capital program for the remainder of the year. So, looking back at the quarter, overall, happy with the balance sheet.

Usage was down $12.7 million. The WRAM, MCBA is working.

That net benefit was booked at $5.8 million for the quarter and really the swing that we saw this year versus last year on an EPS perspective was driven, one, primarily by the mark-to-market adjustments that shows up below the line in other income expense coupled with an increase of about $0.01 from other operations, $0.02 for maintenance and then $0.02 increase on a per share basis for interest costs. So, with that, Stephanie, why don't we open it up for questions from people on the call, please?

First question is on the mark-to-market, is this something that you do quarterly and it just showed up significantly here in the second quarter and how should we think about that going forward?

It is something we have to put quarterly and again these are assets that are held as part of the company's retirement plan and the non-qualified retirement plans. So, yes, were required under GAAP to book the mark-to-market adjustment.

We look at it and frankly, it's monthly. So, it does move around and as, I'm sure you know, that the stock market was very volatile and did not have the best performance during the month of June and so when that tends to happen the mark-to-market adjustment goes the way we don't like it.

It all goes negative. The flip side is a year ago that mark-to-market adjustment was a positive $1.8 million.

So, it does bounce around. That's why we have it below the line in other income and expense.

So you get a fair sense of how the utility is operating versus some of the other assets that's owned by the company. So, it will bounce around every month and as long as the VIX index is high and as long as there is a lot of volatility in the stock market it's going to affect those assets.

On the settlement agreement, understanding that the commission isn't locked in to, to going forward with the agreement, can you just talk historically how the commission has viewed these settlement agreements and if you've had any discussions with the commission on it, any indications they might be providing, one way or the other?

Actually we can not have discussions with the commissioner about this because it's an open proceeding and probably more key to the settlement is the administrative law judge's position to see we will be taking settlement and then writing a proposed decision and as the cases unfold up here, this judge has been very encouraging for us and the staff to settle all the issues. So that's a very good indication that he wants to see a settlement and does not want to make up new issues or rule on issues or litigate issue.

I think that's a good sign that this settlement is pretty good. It's long, 600 pages long.

It took us weeks and weeks to work through with the DRA staff. But I think the signs are all good.

My last question is on CapEx, can we just get the number for in the quarter and if you're still on target for your 2010 guidance?

Yes, the 2010 guidance we gave this year was $125 million. So we have completed $45 million year-to-date.

Typically if you look at our cycle we do more CapEx in the second half of the year than the first half of the year. We feel like we're on track right now.

The other point, I'll just emphasize what Pete said, in the General Rate Case we did get the bulk of the capital that we requested and we have approximately $380 million of capital projects that were approved. Some via advice letter approximate $61 million made of the advice letter, some other projects that are covered by separate proceedings.

There is $45 million of new capital that's cover in the General Rate Case.

Okay, to be clear, the $7 million, you could recognize that only after the project has been completed?

That's true. There are multiple projects in that category.

We build the project, put in it operations, close it and then file the advice letter with the commission for new rates.

So what this is essentially does for you on the call, the capital spending that Pete and I talk about when we were out on the road. We talked about the fact we don't see that coming down anytime in the next four to five years and basically the capital that we're getting is part of these proceedings supports the position we have been taking and advising the street on.

I was wondering if there is any possibility that immediately following the election that there could be new Commissioner is appointed that would rule on this case or if there is a possibility it could be pushed into next year and there would be new commissioners?

There has always that possibility because of course we can't control the schedule here. We don't expect that to happen and the commission's own timeline calls for a decision before the end of the year.

So it's possible it would go further but we don't expect that to happen. If that were to happen we would expect rates to be back billed to the first of the year and the commission, I would say, likes the see settlements.

They don't like to see litigated cases and I think that consistent with all the five current commissioners. So I feel pretty good about the expectation that it should be decided and concluded this year.

I was wondering if there is any big pieces of the difference between the $70 million request and the $34 million settlement. If you could reconcile, maybe, some of the bigger pieces of what you agreed to?

As you know, like most people on this call, we have been in a transition period as California has been adopting the water action plan. So this is the first time we filed all 24 districts in the State of California.

The original request that was filed was for $70.6 million. Now, since that filing, we did receive $9.2 million of step increases in 2009, so you got to take the $70.6 million, subtract the $9.2 million.

We are about to file $4.2 million of new steps for 2010. So you have got to back that off the $70.6 million.

So, you got to take those things into consideration when you look at that, plus the revenue requirement associated with the advice letter projects. When you look at those projects that were on an advice letter basis, and you add this all up and compare the original request to what we ended up, we got about 79% of what we requested, which we think is a very, very good number, and you have got to really sit down and pencil out the numbers to have that number come up, because this is stretched over a longer period given the fact that's a transition period, almost like stub period that we are going to the 24 districts and there's an extra six months here no rate release, but overall, all that competes.

I think we are very happy with the settlement agreement. We are very happy with the process.

As predicted 2010 would be one of the more tighter years for Cal Water in some time, because you have this extra six-month delay of rate release, but the flipside of that is the company is doing a good job at managing its SG&A. So, we feel really good going into the second half of the year.

Then I was wondering, I know that you have the revenue adjustment mechanism to mitigate any earnings impact, but I was wondering if you could talk a little bit more about consumption patterns and what you are seeing as far as transformation and?

That's why every quarter we go around and around how to explain what's going on because you've got two things in a twine. You have overall conservation and one of the effects of conservation coupled with still the effects of the weather and frankly for Cal Water and California, we really to see a big pick up in demand until we really got to June and I think that was driven by the fact that we had a wet year this year, spring seem to be prolonged and really we didn't see a change in our unbilled revenue.

The unbilled revenue is really the accrued revenue. So, when we closed out for months we have revenue that's covered by the WRAM and that's actual build consumption and then we have the unbilled revenue, which is accrued revenue, which is outside the WRAM.

So, that unbilled revenue is a key indicator. So, in May that number continues to go down, and then finally in June it reversed to start going up.

In terms of what's the bigger piece conservation are whether we don't have an answer for that, but overall it was down about $12.7 million for the quarter.

I think it's nice you didn't say you represent Lance Armstrong in your analogy.

I am with the Cal Water team here.

I was wondering if you could maybe walk through a little bit more with the WRAM and MCBA. I am wondering about the $5.3 million decrease from the reduction in customer usage.

I thought you might be a little more insulated there, maybe there if there any comments you can make on how we might want to think about that in Q3?

In fact at our board meeting yesterday, we spent a lot of time talking about this with our audit committee explaining to them as well. Essentially in the General Rate Case, when you have a General Rate Case and you're decoupled, you have adopted revenue numbers and you have adopted production costs.

The revenue is covered by the WRAM but production costs are cover by the MCBA. So adopted revenue less adopted production costs give you gross margin dollars.

Those gross margin dollars are fixed, so if demand instead of having a $118 million of sales, say we had a $1 billion of sales in Q3. The way the mechanisms work, we would have the same gross margin dollars.

So it wouldn't necessary effect EPS from a gross margin perspective. With customer demand being down and customer consumption being down for the quarter production costs came in below the adopted numbers.

You have a WRAM number. The net amount was $5.8 million but included in that $5.8 million was the $5.3 million adjustment or frankly give back to the right payers due to production costs being below the adopted number.

I know this is close a fuzzy concept and it's new in the water industry but really essentially what we're saying the gross margin dollars are fixed when you get a General Rate Case resolved really you can look at what the gross margin dollars are for the year and look at how the company is tracking at those gross margin dollars on a year-to-date basis. For Cal Water and where we are there are approximate $271 million gross margin dollars that have been allocated as part of our last General Rate Case for the State of California.

We have achieved $127 million of those gross margins. We have obtained those, that's what we concluded so far.

So we hit about 46.9% of our target. That means essentially in the second half for the year there is $143 million gross margin available or approximately $17 million more to what we had in the first half for the year.

The reason being, you have a curve that's shifts mid-year to the second half of the year, because the allocation follows our historical sales pattern. So we historically have had better sales in the second half of the year and the distribution of those gross margin dollars follow that curve.

If that doesn't scare the hell out of you, I don't know what does.

Yes, it will. It still helps but sure it is still a little confusing at the same time.

What about the $7 million for the capital projects. Is there anything you can tell us on when we might anticipate those coming online?

Those are over, and I forgot how many there are in that category, of about (inaudible), there is, anyway, scores of projects in there and they are spread out over the three-year period. So, of course, they are important to us to get, build and put in place early.

Let me ask another way, we all saw what happened in 2010. Do you think most of this will come in 2011 or is this more of 2012 event?

I guess more in 2012, late '11 or early 2012. There are 66 projects I see in my notes here, almost 66.

So you can see that they're all, and there is no huge project in there but they are ones if you build normally in our process something like a new well. It's pretty hard to determine when you can get the permits to drill the well.

Will it be a good well? Can you get me all treatment on all those kinds of things?

So the projects are solid. It's the scheduling that's uncertain.

Jim, as we talked about in the past too, this can be fairly lumpy. By the time you get a project, that you have a project you want to get done, you got to go find, take a well, find the land to drill the well, then you have to get the permit to drill the well, and then you have drill the well and the Department of Health Services have to sign off and then you put in operations.

So, it can be fairly lumpy, but as we've talked about and I think as we've proven overtime here, we've gotten pretty good scheduling our capital and budgeting our capital and hitting our capital targets every year. The other interesting fact from the General Rate Case is that we got a nice big slide of capital in the General Rate Case, but then we have a nice big slide of the advice letter projects, and so when you look at the capital spend going out for the next four years, we are going to be right about it, say $125 million to $150 million a year going out.

So, we feel real good about the allocation of capital dollars that we are getting and we have no shortage of good projects or to spend those capital dollars at.

One last question. Is there anything else you can tell us about the O&M contract in Hawaii?

Anything about revenues or what do you think the impact would be?

Jim, it's pretty small. You won't see it move the needle here, more of a strategic issue for us to fill-in that area, and just to give us a better footprint and make us better economy of scale.

My questions have all been answered, so I'll just jump back in the queue.

Quick question, not to be the dead horse, but I am still trying to understand this life insurance contract in the mark-to-market treatment. I wondered, Marty did you say it was a $1.8 million gain in the second quarter last year on a negative $7 million this quarter?

That's correct.

Are those net or is that a gross number?

There is no net or gross, it's just the overall swing. So, I gave the two goal posts so you can see what the swing was from last year to this year, because it explains the big part of the variance in earnings per share.

That's my question. If we look at this on an EPS basis, it was an almost $0.09 gain in last year and now it's a negative $0.03 loss, so our swing is $0.12, is that right?

That's pretty close, yes.

Okay, and what is keeping you on an accounting basis from making this below the net income line items so that we can see the company's true earnings potentials with this removed a bit more cleanly.

That's exactly why we have it in the other income and expense line. So it shows up with non-regulated business.

It doesn't co-mingle with the utility business per se and their accounting standards around this and we have to follow those accounting standards.

There are other items that fall in to the other income, right? What wouldn't keep you from making this its own line item?

No, no, it wouldn't, at least not yet, no, but your points now is that there is a sizeable asset or set of assets that are sitting there that are swinging due to volatility in the market. I asked to do the GAAP research and see if that's certainly can break out on a separate line item basis, but that has not come up yet with our public accountants.

Great, well if there is no other question. We covered a lot of topics and we shared a lot of data here today.

Certainly, the WRAM and the MCBA can be confusing if anyone has any questions on that, please feel free to give us a call especially now that we announced earnings, as we talked about throughout starting the third quarter of last year 2010 as predicted it could be a tighter year for Cal Water. The fact that we've had inflation that's affected our steps with that lower than expected steps.

We have this extra six months of not having rate related to the transition for General Rate Case. The flip side of it is we feel the company is doing a good job of managing it's SG&A and understanding the WRAM components and how they work and that coupled with the General Rate Case result, that's in the propose settlement be increased capital that we're getting a strong balance sheet.

We believe we're positioned very well for the next four years assuming the settlement goes for the commission. We want to thank everyone for hanging with us and if you have any questions feel free to give us the call.

Have a good day. Thanks.